Educational Articles

Using a Value Line Report: Merck’s Yield is Enticing, but What About its Future?

Reuben Gregg Brewer
| July 13, 2012

Merck & Co. (MRK – Free Merck Stock Report) is best described as a pharmaceuticals company. However, as the Business Description states, it’s business is more than a single word; it is a global health care company operating in the prescription medication, vaccine, biologic therapy, animal health, and consumer products spaces. Like its competitors, Merck has been dealing with a difficult operating environment for several years.

Indeed, the entire pharmaceutical industry has been hit hard by patent expirations and weak drug pipelines. The pain has been particularly acute with regard to the largest industry participants, like Merck and fellow Dow-30 components Pfizer (PFE – Free Pfizer Stocl Report) and the vastly more diversified Johnson & Johnson (JNJ – Free Johnson & Johnson Stock Report), where a handful of blockbuster drugs had historically been the driving force behind financial performance. The idea of having just one or two major “hits” works so long as new “hits” come along to pick up the slack when patent exclusivity expires on older drugs. Over the past few years, in several cases, big drug companies have sustained material revenue declines that stemmed from key patent losses.

In particular, Merck has taken some pretty big hits this year including the loss of patent protection on Cozaar/Hyzaar, the soon to come August loss of Singulair’s patent, and Pfizer’s loss of patent protection for Lipitor, which is also impacting Merck’s Vytorin/Zetia franchise as customers move to the cheapest option in the cholesterol space. The next few years look to be pretty difficult for Merck. Value Line’s Michael Ratty projects earnings over the three- to five-year period of $3.70 per share. That is below 2011’s results ($3.77 per share), and below his share net estimate of $3.85 for 2012. The three to five year projection is actually identical to his 2013 estimate. (These figures can be found in the Statistical Array, with estimates presented in bold type and projections found to the right of the headings, also in bold.)

This is clearly not a compelling picture. However, the company has been awarded Value Line’s highest score for Financial Strength (A++, found in the Ratings box). A modest level of debt (22% of the capital structure, as shown in the Capital Structure box), ample cash ($15.5 billion at the end of the first quarter, as noted in the Current Position box), and a lengthy history of solid earnings (which can be seen in the Statistical Array) all back up that assessment. From a purely statistical standpoint, the stock price has a Price Stability rating of 85 (out of 100), which is good, though not exceptional.

Financial Strength and Price Stability get combined to generate the Safety Rank, which can be found in the Ranks box. Here, Merck earns a top-notch score of 1 (Highest). Clearly, Merck isn’t going to go out of business because of patent expirations. This gives it time to find a way to get revenues and earnings back on track. While flat earnings over a three-to-five-year period isn’t a great prospect, if Merck is capable of earning $3.70 a share in its lean years, the upside potential is promising once it rights the ship.

Part of the company’s ability to remain solidly profitable has been its focus on cost cutting. One thing the company didn’t do, however, was cut back its research efforts. Ratty believes that its continued investment here will pay off longer term, as new drugs come on line. That said, drug development can be a lengthy, and risky, process. So while Merck has a solid pipeline, there are no obvious near-term “home runs.” This fact underpins Ratty’s cautious longer-term projections.

Still, the shares are trading near historically low valuation levels. The relative P/E is just 0.74, found in the Top Label, which is near the low end of the historical range for Merck (annual relative P/E figures can be found in the Statistical Array). This has left the company with a dividend yield (around 4.0%) that is also toward the high end of its historical range. That’s a well above the market yield, allowing those with an optimistic view of the company’s future to get paid to wait.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.